The Right Way to Measure Performance

The one thing that matters more to investors than profits is the change in a company’s profitability. The level of profits is the key determinant of value, but the change in profitability—what I call profitability performance—is what drives changes in value and stock-market returns. Stocks outperform the market when profitability improves more than investors expect. Even a company deeply in the red can see its stock soar if it reduces its losses by more than investors had hoped.

The best measure of profitability, as I noted in my last post, is EVA margin. It is the true bottom-line measure of how much economic profit, or EVA, a company produces per dollar of sales. But no margin measure by itselfcan provide a complete and reliable reading on profitability performance. That’s because all margins are affected by changes in sales, which is something that all of them ignore. Say a company increases its sales at a positive EVA margin, but a lower one than the margin on existing sales. The average margin on total sales will fall, but performance actually has improved and shareholders are better off because the company has earned a higher economic profit.

So how do you gauge profitability performance? With a measure called EVA Momentum, which captures both the change in a company’s EVA margin and the impact of sales growth in a single measure. Created by Bennett Stewart, the chairman of EVA Dimensions, EVA Momentum is defined as the change in a company’s economic profit in one period divided by its sales in the prior period. It is the first and only measure that can be used to compare and rank the profitability performance of companies in multiple industries. That’s because EVA automatically risk-adjusts profits by charging for the opportunity cost of all capital, including equity, and because EVA Momentum is scaled by sales. The measure even allows direct comparisons of profitable companies with unprofitable ones.

EVA Momentum also is the only performance ratio for which a higher level always is better than a lower one, something that cannot be said for return on assets, return on equity or even earnings per share. And it has one other interesting facet—a clear dividing line between good and bad performance. The dividing line is zero. Any positive reading for EVA Momentum is good because it means EVA has increased, and any negative reading is bad. A score of zero means that a company’s economic profit has not changed and it is just running in place.

While it is not intuitively obvious, EVA Momentum is mathematically equal to the change in a company’s EVA margin plus its sales growth rate multiplied by its concluding EVA margin. The first factor captures all the changes in the efficiency of a company’s operations, spanning the income statement and the balance sheet. The second captures the performance impact of sales growth or retrenchment.

Levels of EVA Momentum ordinarily are quite small, which is to be expected given that it is the change in economic profit—not the level—divided by sales. The median EVA Momentum score for public companies in the U.S. over the last 20 years has been just 0.3%. The last two years have been anything but ordinary, of course. The recession clobbered profits in 2009 while last year’s rebound produced unusually high profits gains—and unusually high EVA Momentum. The median EVA Momentum among the Fortune 500 turned negative in 2009 and snapped back to 1.4% last year.

The highest readings for one-year periods can be quite high, and they were exceptionally high in 2010. The best EVA Momentum score last year was 93.1% for Chesapeake Energy, while the 2009 high was 54.7% for Legg Mason. Extremely high readings become increasingly rare over longer periods, however, since it is quite a feat to sustain the growth in economic profit at a high percentage of sales. Over a five-year period, a cumulative EVA Momentum of 15% to 20% (3% to 4% a year) usually will put a company at the 90th percentile or higher.

The top 25 performers in the S&P 500 for 2010 are shown in the table below. (You can download a pdf of the EVA Momentum for the entire S&P 500 at www.evadimensions.com.) Unsurprisingly, the top performers last year were heavily populated with rebounders, with many of them coming from the oil & gas and financial services industries. All but four were recovering from negative EVA margins in 2009, and six still had negative margins in 2010. Five of those—Bank of New York Mellon, Citigroup, Legg Mason, E Trade and Keycorp—were financials. The sixth was Versign. The four that were in the black on an EVA basis in 2009—Altera, Linear Technologies, Microchip Technology and Analog Devices—all were semiconductor companies.

Nine of the top 25 merit special attention because they have been consistent winners, placing in the top 10% of the S&P 500 on five-year cumulative EVA Momentum. Five of those are the semiconductor companies, the four mentioned above plus Teradyne. Two, surprisingly, are oil & gas companies—Pioneer Natural Resources and Southwestern Energy. The other two are Cliffs Natural Resources and Versign.

As Forbes.com has observed before , there is a strong correspondence between EVA Momentum and stock performance. But like all things in the stock market, the link is messier than one would prefer. Stock performance depends not just on EVA Momentum over a given period. Another critical factor is the amount of EVA Momentum investors expected going into the period. Apple’s stock, for example, has performed so spectacularly over the last five years because it has produced about three times the EVA Momentum that investors expected. Stock performance also depends on how the company’s performance and other factors cause investors to modify their expectations going forward.

Investors don’t think in terms of EVA Momentum, of course, but it is possible to calculate the amount of future EVA Momentum that is implicitly baked into a company’s current stock price. My company uses that “market-implied” EVA Momentum as one of the factors in its assessment of relative stock valuations. And we currently believe that ten of last year’s top 25 EVA Momentum performers are priced so low that they qualify for buy recommendations. In our ranking system, a buy rating means they are more attractively valued than 80% of the companies in their industries. The ten are AMAT, CLF, APA, KLAC, VRSN, LM, TER, ADI, NVLS and LLTC.